In China’s Credit Ratings, Democracies Pay a Price

The U.S. trade war with China is morphing into an all-out economic conflict between the world’s two largest economies. Some worry that China could open a new front by dumping U.S. Treasurys or devaluing the renminbi or could hamstring U.S. military hardware by cutting off the supply of rare earths. But there’s one possibility nobody has considered: a ratings war, where China tries to persuade the world to take on its own assessments of sovereign debt.

That’s mostly because no one takes China’s credit ratings seriously, least of all Chinese debt issuers and investors. But although the prospect of dueling ratings isn’t likely anytime soon, some countries are increasingly comfortable with the Chinese rulebook.

China’s distinctive credit rating system offers a transparent window into what a world run according to the norms of the People’s Republic would look like. The view is crystal clear yet deeply unnerving: It would be a lot costlier for democracies and their citizens—and a lot more comfortable for autocrats and kleptocrats.

The power of ratings

Credit ratings emerged in the early 20th century as a way for investors to understand the risks associated with stocks and bonds. The simple rating scale, which is topped by the famous “AAA,” or triple A, is meant to indicate how likely issuers are to default on their debt obligations. A higher rating means lower risk, which translates into a lower interest rate issuers need to offer investors.

Moody’s Investors Service, Standard & Poor’s (S&P), and Fitch Ratings, which pioneered the ratings industry, all began by rating stocks and corporate bonds. Moody’s was the first to rate a government bond in 1918, but S&P issued the first “sovereign rating” in 1941, when it gave a AAA rating for the credit worthiness of the U.S. federal government as a whole. But the number of countries receiving sovereign ratings did not expand substantially until the late 1980s, after the debt crises of the 1970s and early 1980s had passed. Today, Moody’s has the widest coverage, with 135 sovereign issuers, followed by S&P with 131, and Fitch with 109.

The power of ratings comes from the reputation of the ratings agencies for having a consistent record of accuracy but is backed up by U.S. government regulation. In the mid-1970s, the U.S. Securities and Exchange Commission started licensing raters, and other U.S. laws mandated that investors are only permitted to buy debt rated highly by these agencies. The size and importance of the American debt market turned this national oligopoly into a global one. The regulatory stranglehold of the top agencies was lifted in 2010, with the Dodd-Frank financial reforms, but the investment community still depends heavily on ratings.

As a result, the monetary authorities of governments the world over have a love-hate relationship with the agencies because their verdicts can save or cost them billions of dollars in interest payments. No government has ever complained of being rated too highly, but they often gripe about being disrespected and misunderstood with low ratings.

China’s industry

A small number of other rating agencies have emerged in the shadow of the Big Three in the United States, Europe, and Asia. They primarily focus on niche markets that draw on their familiarity with specific economic and political circumstances. China’s ratings industry dates to the early 1990s, when liberal reformers determined that for China to have a modern financial system it would have to develop its own bond market and rating agencies. One of the first was the nonhumbly named Dagong Global Credit Rating. (Dagong means “great commons.”) Like others, its first decade was nondescript, as China’s bond market was tiny, opaque, and totally state-controlled. Investors were barely aware of these agencies’ existence.

China’s bond market did eventually expand dramatically in the mid-2000s, and the rating agencies grew alongside it. But despite appearing similar to their American cousins, Dagong and the other Chinese raters have hardly been titans. China’s debt market is huge, and issuers are required to obtain ratings from a select number of licensed agencies, among them Dagong, but ratings are largely irrelevant because of state intervention and endemic conflicts of interest.

On the front end, the government has created high hurdles for issuers, favoring state-owned enterprises and companies whose plans jibe with industrial policy goals. On the back end, thanks to these ties to the state, authorities provide an implicit guarantee to investors that bonds won’t go bust. And save for a modest bump in defaults lately, investors have not had to worry. To top it off, the issuers pay rating agencies for the ratings (a common problem in the United States), which has contributed to a unhealthy dose of ratings inflation. It’s no wonder then that the vast majority of Chinese bonds are rated AAA or AA.

Dagong’s Sovereign Ratings

Source: Bloomberg’s credit profile for Dagong’s current sovereign ratings.

In this morass, Dagong’s entrepreneurial chairman, Guan Jianzhong, found a way to stick out from the crowd. In July 2010, to everyone’s astonishment, Dagong jumped into the sovereign ratings mix, issuing ratings on 50 countries. Appearing to play the nationalist card, Dagong turned the world upside down by giving China a prestigious AA+, far above the more pedestrian ratings from Moody’s, S&P, and Fitch of A1, A+, and AA-, respectively.

By contrast, the United States found itself with only a AA rating instead of the AAA it had received from everyone else for decades. Dagong claimed that China deserved a higher rating because of its rapid growth, large storage of foreign exchange reserves, and low government debt, while the United States should be graded lower because of its slower growth and massive budget deficits. The news garnered a collective chuckle from the Western financial community, and then everyone returned to ignoring what they interpreted as Dagong’s public relations stunt. Despite being dismissed, Guan and Dagong pressed on, and by 2018 the firm covered almost 90 countries.

Authoritarian bounce and democratic penalty

Although irrelevant as a guide to current investment, Dagong’s ratings tell a much larger story. Although the Chinese Finance Ministry likely welcomes Dagong’s ratings, my sense is that Dagong is not a state puppet and that its ratings are created entirely in-house. And like with rating agencies everywhere, that means the task falls primarily to a group of analysts in their 20s, all of whom have studied finance and many of whom have spent time in the United States and Europe. Dagong must have been aware that its approach would be welcomed by officialdom, but its rating analysts are not sheltered slaves but rather some of China’s most cosmopolitan youth.

A comparison of Dagong’s ratings with those of the industry’s global leaders from 2018 yields a fascinating picture. (The agencies use slightly different ratings scales; for analysis purposes, we standardized them, and, here, follow the S&P nomenclature.) About half of all Moody’s and S&P ratings are identical, and those with differences are quite small, usually just a single notch, for example, from AA to AA-. By contrast, only 31 percent of Moody’s and Dagong ratings are identical, and just 26 percent of those by S&P and Dagong are the same—and often these gaps are quite pronounced.

The easiest way to appreciate these differences is by examining them on world maps. Countries where Dagong’s ratings are higher than those of Moody’s are red and where they are lower are green (the darker the country the greater the difference).

Dagong/Moodys Ratings Difference

Source: Bloomberg’s credit profile for Dagong’s current sovereign ratings.

Just as it said in 2010, Dagong still claims that its ratings are distinctive because they put greater weight than those of Moody’s and S&P on countries’ growth potential and fiscal position, which theoretically leaves them better able to generate income and resources to cover any debts. But a careful statistical comparison of the ratings brings these claims into doubt. None of the differences between Dagong and its U.S. counterparts can be explained by any economic variable—not growth rates, level of economic wealth, or even debt-to-GDP ratio.

The only factor that definitely matters is politics. Dagong underrates democracies and overrates authoritarian regimes.

An overlay of Freedom House’s classification of countries as free, partly free, and not free according to their degree of political freedom yields a clear pattern: Dagong rated 30 countries categorized as free lower than Moody’s or S&P while giving a higher rating to only 12 free countries. An analysis using the Economist Intelligence Unit’s regime-type scores of democracy (ranging from 1 to 10) yields the same result. If a country is rated one point higher (suggesting it is more democratic), Dagong on average gives it a one-unit lower credit rating. Moreover, Dagong is 70 percent less likely to rate a country higher than Moody’s or S&P if that country is democratic.

These findings do not apply in every single case, but they are extremely common. Four of the five countries receiving the biggest bump by Dagong are classified as “not free”: Oman, Russia, China, and Saudi Arabia. The fifth is South Africa, a member of the BRICS nations alongside Brazil, Russia, India, and China. By contrast, democracies typically fare poorly, as is visible with not only the United States but Iceland, Argentina, and Ukraine.

What’s the bill?

Because no one pays attention to Dagong’s sovereign ratings, they have no real-world significance other than as an ideological snub of the West. But that might not always be the case. Two-way capital flows in and out of China are likely to rise, China’s capital markets will at some point deepen, international use of the renminbi for trade and finance will eventually rise, and China will have a bigger voice in the International Monetary Fund (IMF) and other international financial institutions. Combine the possible growth of China’s global financial gravitational pull with an extended period of fiscal and financial troubles in the United States and West that undermines confidence in the global rating agencies, and China’s raters may finally get their day in the sun.

Technically, it is not easy to quantify the value of a shift from one ratings system to another because such massive changes in ratings, either downgrades or upgrades, are unheard of, and many factors can shape the interest rates of countries. That said, we can make an educated guess of what the change in costs would be by making a couple of reasonable simplifications in how the interest rate would change should a country’s rating rise or fall. Assume a very small, fixed 0.05 percent change in the interest rate for each notch change in ratings. (A three-notch change would mean an interest rate difference of 0.15 percent.) Another option, which is likely more realistic, is a graduated shift, with the first notch difference resulting in a 0.05 percent change, the second a 0.10 percent change, and so on. (A three-notch shift using this method would be a 0.30 percent interest rate change.)

The Democratic Deficit: Summary of Estimated Changes in Debt Interest (billions of U.S. dollars)

Sources: Center for Strategic and International Studies calculations based on data from Dagong, Moody’s, Freedom House, and the IMF.

The results are absolutely astounding when these changes in rates are used to show how much countries would pay to service their national debt under Dagong’s rules. Using the first “fixed” method yields a total annual change in interest payments on debt of $112.7 billion for the world, while the more realistic “graduated” method results in a change of over $370 billion. If the world adhered to Dagong’s ratings, “free” countries would face an increased annual interest payment bill of $327.5 billion, while “not free” countries would receive a collective refund of $36 billion. The pattern is almost identical if one compares the leading industrial nations of the G-7 with the BRICS.

Ratings Winners and Losers: Estimated Changes in Debt Interest for Select Countries (billions of U.S. dollars)

Sources: Center for Strategic and International Studies calculations based on data from Dagong, Moody’s, Freedom House, and the IMF.

Not surprisingly, China comes out ahead, saving itself up to $34 billion annually. The United States is the biggest loser. Multiplying a seven-notch deterioration in its rating by its $21.7 trillion national debt results in a higher interest rate bill of between $76 billon and $304 billion. Per year! To put that figure in perspective, the total U.S. federal government deficit in fiscal year 2018 was $782 billion. This additional interest charge would raise the deficit to almost $1.1 trillion. To fund the additional interest payments would require a tax of $928 for all 327 million Americans. Alternatively, President Donald Trump’s wall at the southern border would cost only $70 billion, and there would still be enough money to fully fund high-speed rail between Washington, D.C., and Boston ($151 billion) and between Los Angeles and San Francisco ($98 billion).

Looking ahead

Dagong’s ratings have not been adopted by China or anyone else, but they serve as a potential incentive system for governments and investors. Moreover, they reinforce other prominent norms favored by Beijing, including state intervention in the economy and regime control of information and the internet. As China’s influence grows, investors, producers, and other governments may not only make peace with these norms but make them the default.

The United States and other democracies certainly need to counter Chinese interventionism, outright coercive actions, and subtler forms of political influence. Yet the most important path to ensuring that Dagong’s values don’t become the world’s values is to strengthen democracies and their ability to not only provide freedom but to effectively govern and address the full range of societal challenges that increasingly impact daily life and financial well-being. These include achieving inclusive growth, harnessing technological innovation and limiting its negative effects, ensuring public safety, addressing pollution and climate change, and reducing interstate conflict. The more democracies walk the walk, the greater their success—and the less attractive authoritarian systems that propose an easy shortcut to prosperity and power will be. If so, the political bounce that the United States and other democracies receive from credit rating agencies will be deserved and endure.

Democracy is expensive no matter what. Citizens can work diligently to protect and nurture it, or they can start cutting checks to Dagong once it achieves hegemony over the ratings world. The smart investment is obvious.

Mingda Qiu and Angela Deng contributed research to this piece.